INTRODUCTION of governance, risk management, pay practices and ownership

INTRODUCTION

The run-up to the global financial
crisis was marked by excessive risk taking in financial sector and once the
crisis hit, the accumulated risks led to systemic problems and the failure of
many individual financial institutions. The causes of such risk taking by banks
were many and complex. This paper aims to contribute to the academic
understanding of what drives risk taking by banks. There are few main factors
that are related to risk in bank system such as characteristics of governance,
risk management, pay practices and ownership structures. To tackle the issue of
risk taking by banks, there are some solutions to improve the regulation of
corporate governance and regulating bank’s compensation. Furthermore, some adjustments
should be added to enhance board oversight of bank risk and to ensure that
executive pay imparts the appropriate incentive to absorb the risk (Marques and
Oppers (2014) page number missing). In addition,
some policy initiatives recommended by IMF will be mentioned to control the
risk taking by banks.

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SECTION 1: The main factors involve creating risk taking by banks

This section would be focused on
explain some important factors which are connected to risk taking by banks.
These are including board characteristic, compensation, ownership structure and
risk management and culture.

1.1.      Bank
governance and risk taking by banks

Board independencies connected
with lower risk. A board that is more independent of management may be better
placed to supervise and control risk taking. This is especially crucial when
executive compensation (designed to counteract the managers’ natural
risk-aversion) gives managers incentives to take too much risk. The CEO chairs
the board variable (English?) also
appears to be associated with higher risk taking in banks, reinforcing the
important role of board independence in curbing risk taking. Board financial
experience is associated with increased risk in banks. This suggests that board
members with financial experience are generally more comfortable with the bank
taking more risk. However, the regression (where?) using
2008 data shows the opposite effect, suggesting that more financial experience on
the board may guard banks against tail risks or enable boards to better manage
the consequences if these risks materialize. (International Monetary Fund
(2014) page?).

1.2.      Pay practices and risk taking by banks      

A higher share of salary
(fixed pay) is associated with higher risk, but only for small banks (with less
than $10 billion in assets) (Marques and Oppers (2014)). This may illustrate
different compensation practices, reverse causality. For instance, smaller
banks have a low charter value, which tends to lead them to take on more risk.
Taking on more risk, in turn, means that their managers will require higher
fixed pay. In terms of larger banks, however, higher risk is usually associated
with higher complexity, which demands delegation of responsibilities to
managers, but also a higher share of variable compensation. In line with the
existing empirical literature, the relationship between cash bonuses and risk
is vague. There is generally no relationship using cash bonus as a proportion
of total compensation, but an alternative measure (bonus as a share of salary)
shows a positive association with risk during the crisis (Marques and Oppers
(2014)).

Equity-linked and long-term
incentive pay is associated with less risk in general. The same holds for
restricted stock awards. Restricted equity awards can lead to enlarged risk
taking if the bank is close to default but the opposite is true  if the default probability is low because of
managers’ incapability to diversify personal risk (related to their job tenure
and personal wealth invested in the firm). The impact of equity awards on risk
taking during the global financial crisis was much higher and significant for banks
closer to default, which suggests that extending the horizon of compensation reduces
the incentive for managers to favour short-term risks.

The level of compensation
(fixed plus variable) is not consistently related to risk taking. The level of compensation
(adjusted for bank size) was related to higher risk taking during the global
financial crisis (Cheng, Hong, and Scheinkman (2007)), but the other approaches
show that it is either negatively or not significantly related to bank risk.

1.3.           Ownership structure and bank’s risk

In general, institutional
ownership is associated with less risk taking, and insider ownership is not
correlated with risk. However, the presence of institutional investors and of
large insider ownership correlates with more measured risk (Marques and Oppers
(2014)). Corporate insiders (managers) or institutional investors hold a higher
fraction of the ownership of the company should show less risk taking if the
bank is financially strong, because they have a lot to lose. When the firm is
close to defaulting on its debt, managers have less to lose by taking more
risk. In fact, the latter result can be seen as indicative of a significant
gambling-for-resurrection problem, captured by the 2008 crisis regression (Marques
and Oppers (2014)) .

1.4.           The relationship between risk
management and culture with risk taking by banks

The signal on the effect
of risk controls is mixed. It suggests that although risk controls may support
manage risks in general, they may not shelter the bank from tail risks. The
existence of a board risk committee is related with lower risk in banks but the
relationship is weak. Only when simultaneously controlling for all governance
variables does the analysis find that a risk committee is significantly related
to less risk.

The professional background
of the CEO (an imperfect proxy for different risk cultures) is connected to the
bank’s risk taking. When the CEO comes from retail banking or has previous
experience in the risk function of a financial institution, banks tend to take
on less risk, with the opposite being generally true for bankers with a
background in investment banking. These results are interpreted as indirect
evidence that risk culture is an important determinant of bank risk taking.

As expected, the
importance of board oversight and risk management is greater in countries with stronger
legal frameworks and government effectiveness However, the association between risk
management indicators and risk taking is not consistently stronger in countries
with strong supervisors.

In sum, the section proposes
that the importance between risk taking in bank with board independence, the
existence of a risk committee, the share of equity-linked compensation in total
compensation, and the share of ownership by institutional investors